Spotify is a classic example of a freemium business model. Spotify monetizes service through both subscription and advertising. They have roughly 116M free ad-supported users who have access to Spotify’s catalog with limited features, and remaining 94M are paid subscribers who pay a monthly subscription fee for premium features. Spotify’s 90% revenue comes from premium subscribers. Thus, the subscription model is a major revenue stream of Spotify.
In subscription business, customer acquisition cost occurs up front and the revenue appears over time. That’s why implementing a subscription business is hard. As evident from Movie Pass’ business, subscription business model could go deadly wrong. Thus, it’s important to evaluate the economics of a subscription business. In this article, I will discuss how much a subscriber is worth to Spotify, their subscriber acquisition costs and how much headroom it leaves for other expenses such as other fixed costs and content related expenses.
Lifetime Value of a Spotify Subscriber
The lifetime value of a subscriber depends on below four factors:
- Average Revenue per user (ARPU): how much subscription fee Spotify charges on average per subscriber
- Cost of Revenue: how much Spotify spends on average per subscriber to support the product
- Customer lifetime: how long on average a subscriber stays with Spotify (which is inverse of churn rate)
- Discount rate¹
Below is the equation to calculate the lifetime value of a subscriber.
I wanted to highlight a few things here:
- Premium subscriber ARPU has been declining YoY due to the growth of low-priced Family and Students plans.
- Spotify has a very high cost of revenue primarily due to royalty payments made to artists and record labels. Generally, 60–70% of revenue that Spotify earns from a subscriber goes to record labels and artists. Besides normal expenses such as payment processing, cloud computing, and streaming facility, cost of revenue also includes amounts incurred to produce content for the service.
- Spotify doesn’t disclose Premium Subscribers churn rate regularly in their financial statements. However, in May 2018 Financial Statement release, they mentioned that the monthly churn rate² has fallen to below 5%, primarily due to the popularity of high retention student and family plans. So, I have assumed 4.5% monthly churn rate in the above calculation,
Considering these inputs, the lifetime value of a Spotify subscriber is $31.1³.
Subscriber Acquisition Cost
Given Spotify is a freemium business, Spotify’s Ad-Supported Service serves as a funnel, driving more than 60% of total gross added Premium Subscribers. That’s why, in order to calculate subscriber acquisition cost (SAC), in addition to the cost to acquire users, costs to support free product should also be considered.
Spotify doesn’t provide data on subscriber acquisition cost. However, the below calculation provides a good estimation of Spotify’s SAC.
In order to calculate SAC⁴, I have calculated sales and marketing costs per gross add. That will provide us the cost to acquire a user. Spotify provides a free one-month trial to acquire premium subscribers. Sales and marketing expense also includes costs of providing free trials (e.g. royalty fees). In order to determine costs to support a free user, I have calculated — the cost of revenue to support free users / total free users.
From the below calculation, subscriber acquisition cost is $16.2.
Conclusion
Spotify makes roughly about $14.9 (LTV-SAC = $31.1-$16.2) from a subscriber. Spotify’s LTV/SAC ratio is ~2.2. For reference, if the LTV/SAC ratio is greater than 3 then the health of a business is considered good.
Spotify’s LTV/SAC ratio is low primarily due to decreasing ARPU and high cost of revenue. Given Spotify makes only $14.9 per subscriber, it leaves pretty small headroom to cover other operational costs. In order to make Spotify’s economics favorable, Spotify should focus on increasing ARPU while growing and retaining subscriber base. Besides Spotify should diversify revenue and be less reliant on the royalty business model. Spotify is moving in that direction. They recently acquired Gimlet (a podcast company with exclusive content) and Anchor (a service for easily making and distributing podcasts).
As Ben Thompson mentioned in the article, Spotify’s strategy with the acquisition of Gimlet and Anchor is a multi-prong:
Anchor provides a way to capture new podcasters, leading them either to Spotify advertising or, in the case of rising stars, to Spotify exclusives. Critically, because Spotify has access to all of the data, they can likely bring those suppliers on board at a far lower rate than they have to pay for established creators like Gimlet Media.
Spotify Advertising, as I just suggested, makes a strong play to be the dominant provider for the entire podcasting industry. Spotify Advertising is already operating at a far larger scale than Midroll, the incumbent player, and Spotify has access to the data of the second largest podcast player in the market.
Gimlet Media becomes an umbrella brand for a growing stable of Spotify exclusive podcasts. Critically, as I noted above, the majority of these podcasts come to Spotify not because Spotify pays them millions of dollars but simply because Spotify is better at monetizing than anyone else.
Thus, Spotify can increase retention by providing exclusive podcast content to premium subscribers, which will provide a better value proposition to the subscribers. They can also generate more advertising revenue by monetizing content of podcasters and can diversify from its high marginal costs business.
Footnotes
¹To keep it simple, the Discount rate is not considered in the calculation.
²When a business reports an input into lifetime value inputs like CAC or churn rate, it is often an average. That may hide the fact that there are big differences in the analysis by “cohort.”
³Few Subscribers also rejoin after churning. For the sake of simplicity and due to lack of data, reengagement isn’t considered in the model.
⁴Spotify didn’t include the cost of revenue to support free users in the calculation of subscriber acquisition cost. That’s why LTV/SAC ratio was higher in their F-1.
